Theories of Inflation

• The two theories of inflation are the quantity

theory and the institutional theory
• The quantity theory emphasizes the connection between money
and inflation; if the money supply rises, the price level rises
• The institutional theory emphasizes the relationship between
market structure and price-setting institutions and inflation

• The two theories overlap significantly, but

because they come to different policy
conclusions
 The Quantity Theory of Money and Inflation

Inflation is always and everywhere a monetary

phenomenon
• The equation of exchange is: MV = PQ
M = Quantity of money Q = Real output
V = Velocity of money P = Price level
• Velocity of money is the number of times per
year, on average, a dollar goes around to
generate a dollar’s worth of income
Velocity = Nominal GDP
Money Supply
 The Quantity Theory of Money and Inflation

Three assumptions of quantity theory:

1.Velocity is constant
2.Real output (Q) is independent of money supply
• Q is autonomous, determined by forces outside those in the
quantity theory

3.Causation goes from money to prices

• The quantity theory says that the price level varies in response
to changes in the quantity of money
• %∆M %∆P
 Inflation and Money Growth
Annual percent
change in inflation The empirical evidence that supports the
quantity theory of money is most convincing in
100% countries that experience significant inflation
Belarus
80%

Brazil
60%
Romania Uruguay
40% Argentina
Ukraine

20%
U.S.
Annual percent
change in the
0% money supply
0 10 20 30 40 50 60 70 80 90 100
Why Central Banks Increase the Money Supply
• If the central bank must buy government bonds to
finance a government deficit, the money supply
increases and inflation may occur
• This inflation works as a kind of tax on individuals,
and is often called an inflation tax because it
reduces the value of cash
• Central banks have to make a policy choice:
• Ignite inflation by bailing out their governments with expansionary
monetary policy
• Do nothing and risk recession
Institutionalist Theories of Inflation
• Both quantity theorists and institutionalists agree that
money and inflation are positively related, but they
have different causes and effects
• Quantity theorists believe that increases in money
cause direct increases in prices
• Institutionalists believe that increases in prices force
government to increase the money supply or cause
unemployment
Institutionalist Theories of Inflation
• According to the quantity theory, changes in
money cause changes in prices
• MV PQ
• According to the institutionalists, increases in
prices force the government to increase the
money supply
• MV PQ
Institutionalist Theories of Inflation
• The source of inflation is firms who pass on higher
wages, rents, taxes, or other costs on to consumers in
the form of higher prices
• If the government increases the money supply so that
demand is sufficient to buy the goods at higher prices,
inflation is the result
• If the government doesn’t increase the money supply
unemployment increases

16-8
Demand-Pull and Cost-Push Inflation
• Demand-pull inflation occurs when the
economy is at or above potential output
• It is generally characterized by shortages of goods and workers

• Cost-push inflation occurs when the economy

is below potential output
• Significant proportions of markets or one very important
market experience price increases not related to demand
pressure
 Addressing Inflation with Monetary Policy
Price level Some policy makers believe
LAS there is a tradeoff between
inflation and unemployment

SAS1
Government can:
Inflationary
P1 Keep output high (AD0)
pressure
SAS0 • Low unemployment
P0 • Higher inflation
AD0
P2 Lower AD (AD1)
• Low inflation
AD1
• Higher unemployment
Real output
Q1 Q0
 The Phillips Curve
• The Phillips curve began as an empirical relationship
• In the 1950s and 1960s, when unemployment was high,
inflation was low; when unemployment was low, inflation was
high
• The short-run Phillips curve is a downward-sloping curve
showing the relationship between inflation and
unemployment when expectations of inflation are constant
• In the 1970s, there was stagflation, the combination of high
and accelerating inflation and high unemployment
 The Phillips Curve
Inflation Inflation
The empirical relationship …led economists to believe
‘68 between unemployment and the relationship could be
‘56 inflation from 1954-68… represented by a
downward sloping Phillips
curve
‘57
‘67
‘66
‘55
‘64 ‘60 ‘58
‘65
‘59 ‘63
‘61 Phillips
‘62‘54
curve

Unemployment rate Unemployment rate

 The Long-Run and Short-Run Phillips Curves
• Actual inflation depends both on supply and demand
forces and on how much inflation people expect
• At all points on the short-run Phillips curve,
expectations of inflation (the rise in the price level
that the average person expects) are fixed
• At all points on the long-run Phillips curve,
expectations of inflation are equal to actual inflation
• The long-run Phillips curve is a vertical curve at the
unemployment rate consistent with potential output
 The Phillips Curve
Inflation Inflation

Long-run Phillips
On the short-run Phillips curve, curve
expectations of inflation can differ
from actual inflation
The long-run Phillips curve
shows the lack of a trade-
off when expectations of
inflation equal actual
inflation
Short-run
Phillips curve

Unemployment rate Unemployment rate

 Quantity Theory and the Inflation/Growth Trade-Off

• Quantity theorists believe that low inflation

should be the priority of policy
• They believe that low inflation leads to
growth because:
• It reduces price uncertainty, making it easier for
businesses to invest in future production
• It encourages businesses to enter into long-term contracts
• It makes using money much easier
Quantity Theory and the Inflation/Growth Trade-Off

Inflation
Quantity theorists emphasize
the inflation/growth tradeoff

Growth
Institutional Theory and the Inflation/Growth Trade-Off

• Institutionalists are less sure about a negative

relationship between inflation and growth
• They do not agree that all price level increases
start an inflation
• If inflation does get started, the government has
tools to get rid of it relatively easily
 Institutional Theory and the Inflation/Growth Trade-Off
Price level

Deflationary Institutionalists
pressures argue that the
inflation threshold is
? Inflationary
at high potential
output
pressures

Real output
Low High
potential potential
output output